Ch15

Chapter 15Chapter 15Government and

Industry: Challenges and

Opportunities for Today's Managers

Managerial Economics: Economic Tools for Today’s Decision

Makers, 4/e By Paul Keat and Philip Young

2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young

Government and Industry

• The Rationale for Government Involvement in a Market Economy

• Doing Business with the U.S. Government

• Government Deregulation, Mergers, and Acquisitions


Government Involvement in a Market Economy

Functions of Government in a Market Economy

• Provide legal and social framework

• Redistribution of income and wealth

• Regulation of natural monopolies



Functions of Government in a Market Economy

• Provide for a competitive framework

• Reallocation of resources in the presence of externalities

• Stabilization of the aggregate economy


Competitive Framework: Antitrust Laws

Sherman Anti-Trust ActClayton ActFederal Trade Commission Act




The purpose of antitrust laws

Two schools of thought

1. Economic efficiency

2. Protection of small independent firms



Dealing with market externalities

Under perfect competition:

• resources are efficiently allocated

• social welfare is maximized



Dealing with market externalities

However, if all costs are not included in the price or all costs are not compensated, market failure results.



A benefit externality (positive externality) arises if certain benefits of the production or consumption of a good or service accrue to third parties.

Producers cannot appropriate all the revenue so too little may be produced.



A cost externality (negative externality) arises if some of the costs of production or consumption of a good or service are borne by third parties.

The product’s price will be lower than if it had been fully costed and too much of the product will be produced.



Benefit externality• Private garden• Information• Innovations

Cost externality• Pollution

Examples



MCp = marginal production cost

MCpol = marginal pollution cost

MCs = marginal social cost



P1 = market price

Popt = socially optimal price

Q1 = market clearing quantity

Qopt = socially optimal quantity



Socially optimal price occurs where the price of the product equals the marginal social cost.

At this point, less pollution will be produced than under competitive conditions. (Qopt < Q1)



How can the optimal equilibrium be attained?

• Government can restrict production to Qopt.

• Government can impose a pollution tax equal to MCpol.

• Government can set maximum pollution levels for the industry then sell (tradable) pollution licenses.



Coase Theorem: The idea that government intervention to eliminate the effect of externalities is not necessary if property rights are correctly and clearly defined.

If property rights (i.e. pollution permits) are assigned, bargaining between the parties involved would result in an optimal solution.



Problems with Coasian bargaining

• Normative issues

• Transaction costs

• Unfair bargaining

• Incomplete information



Stabilization of the Aggregate Economy

• Monetary Policy: the use of the money supply and interest rates by the Federal Reserve System to influence the macroeconomy

• Fiscal Policy: the use of taxes and government spending to influence the macroeconomy



Monetary Policy

The primary goals of monetary policy are to achieve a certain level of economic activity and price level.

Recently monetary policy has involved influencing the Federal Funds rate.



The Federal Funds rate is the interest rate at which banks are able to borrow funds from other banks.

The Federal Open Market Committee determines whether the Federal Funds rate target should be changed.

Monetary Policy



The Fed may have to engage in open market operations to bring the rate to its desired (target) level. Open market operations involves buying and selling government securities in the market in order to increase or decrease the money supply, thus influencing interest rates.

Monetary Policy



Fiscal Policy

Fiscal Policy is designed to achieve macroeconomic goals relating to output and employment.

By manipulating receipts and expenditures, a surplus or deficit is created.



To stimulate the economy, the government will:

• decrease taxes • increase expenditures,

which shifts the federal budget toward deficit.

Fiscal Policy



Policy Lags

• Recognition

• Implementation

• Operational


Doing Business with the U.S. Government

Monopsony: A market in which there is only one buyer.

The government procurement office is often cited as a good example of a monopsony.



What the U.S. government buys is influenced by:

• Government strategic plans• Budget and program input from federal

departments• Priorities set by the President• Availability of appropriated funds• Congressionally mandated requirements• Surplus/deficit conditions• Politics



Government acquisition is controlled by:

• Armed Services Procurement Act

• Federal Property and Administrative Act



• Competition requirements

• Profit restrictions• Audits

• Bid protest rules• Accounting

requirements• Socioeconomic

Programs

Companies doing business with the government must comply with:


Government Deregulation, Mergers, and Acquisitions

From the late 1970’s through the 1990’s the government eliminated most regulatory control in the following industries:

• Telecommunications

• Electric and gas utilities

• Airlines

• Commercial banks



Deregulation has resulted in more competitive environment.

Many companies have sought to merge with or acquire other companies in order to survive and grow.



The basic motivation for mergers is to increase the value of the combined firms.

VA+B > (VA + VB)

V = total market value

A & B = companies involved



Incentives to Merge

1. Synergies in production

• Revenue enhancements

• Operating economies

• Financial economies



2. Improved management

The merger may create an opportunity for improving the overall management level by eliminating poor managers.

Incentives to Merge



3. Tax consequences

The merger may reduce the tax bill of the two combined companies.

Incentives to Merge



4. Managerial power

A merger may occur when the acquiring company’s managers are seeking to increase their span of authority.

Incentives to Merge



5. Diversification

Mergers among unrelated firms was said to decrease the variability of sales and earnings and thus benefit stockholders.

Incentives to Merge



6. Market power

Mergers may decrease competition in an industry, thus leading to higher profits for the remaining firms.

Incentives to Merge



Stockholders of the target firm gain substantially.

Stockholders of the acquiring firm gain very little.

Overall increase in value of combined firms.



Evidence regarding profitability of merged firms is mixed.

Merger activity does not appear to have increased the level of industry concentration.

There appears to be no decrease in research and development of merged firms.

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